Question

Bellevue Company is currently debt-free and expects perpetual annual EBIT of 6,000. Its cost of equity is 16 percent. The firm can borrow at 10 percent. The corporate tax rate is 35 percent. a. What is the current value of the firm? b. What will the value be if Bellevue establishes 50 percent debt ratio? C. What will the value be if Bellevue changes the debt ratio to 100%?

Answer 1

1) Bellevue is currently debt free , which means D=0,

annual EBIT=6,000 for perpetuity:

Cost of equity=Ke=16%

Corporate tax=35%

Current value of the firm :

AS there is not Debt curently therfore WACC=Ke=16% which will be our doscounting factor:

Now EBit=6000

My PBT=6000( assuming all the interest is zero as debt is zero-short + long term debt is considered zero here)

Tax=0.35*6000=2100

PAT=6000-2100=3900

My net cash flows will be PAT, as no depreciation, no interest , no WC, no capex is given:

Year 1 to perpetuity my Flows will be 3900

PV=0+3900/(1+0.16)+3900/(1+0.16)^21.....perpetuity:

We know sum of infinite Geometric progression=a/(1-r), here a=3900/(1.16), r=1/(1.16)Putting in the equation:

we get PV=(3900/1.16)/(1-(1/1.16))=24375

EV=24375

Value of firm =24375

2) if D/E =1/2

Kd=10%

WACC=Ke*(E/E+D)+Kd*(1-t)*(D/D+E)=0.16*(2/3)+0.65*0.10*1/3=12.833%

From the quation I can't calculate interest which getting paid year on year, and therefore tax shield can't be calculated , so we assume same cash flow levels:

PV=0+3900/(1+0.12833)+3900/(1+0.12833)^2+.......perpetuity

PV=3900/(1.12833)*(1/(1-(1/1.12833)))=30390.40

Value of the firm=30390.40

3) if D/E=1

WACC=Ke*(E/D+E)+Kd*(1-t)*E/(D+E)=0.16*1/2+0.10*0.65*1/2=11.25%

Again doing the same thing for cost of capital of 11.25%

PV(present value of all future cash flows)=0+3900/(1.1125)+3900/(1.1125)^2+...... till perpetuity:

PV(present value of all future cash flows)=3900/(1.1125)*(1/(1-(1/1.1125)))=34666.67

Firm value at 100% debt=34666.67

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